Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the
54th Shann Memorial Lecture, Perth, 12 August 2015.

Mr. Lowe's commentary is mostly devoted to Australia, but the issues apply just as well to the U.S., and, in fact, I think the universality of these issues in developed economies may explain how problems that originate in localized housing politics may have aggregated into a problem that affects global fixed income markets. Much of Mr. Lowe's discussion builds around this issue:

almost three-quarters of the increase in the ratio of net wealth to GDP since the late

1980s is explained by higher land prices.

This isn't quite the case in the U.S. It should be, but we threw our housing sector into disequilibrium in 2007. Australia didn't. But, even before that, it looks to me like housing only accounted for more like half of the increase in wealth to GDP in the U.S. I suspect that one reason is that foreign corporate investments are a larger portion of U.S. wealth. This doesn't show up so much in book values in the U.S. capital account, but it does show up in the market value of U.S. corporations. The first factor he cites in raising those prices is lower inflation and less financial regulation. I had originally intuited that as a significant factor in rising home prices, myself, before I began this series of posts. I outlined Friday why I don't think the data confirms that intuition. In addition to the confounding pieces of evidence I discussed in that post, I have discussed previously how rising home square footage is another piece of evidence that looks at first blush like it is a sign of overbuilding, but may actually be a result of supply constraints. Since I wrote that post, I have come to that view even more strongly, since the concentration of those supply constraints in the core cities should cause an even larger substitution of square footage for lot size.

Lowe continues:

The second factor is the combination of strong population growth and the structural
difficulties of increasing the effective supply of residential land....They include the
challenges of developing land on the urban fringe and of rezoning land close to city centres
for urban infill. They also include, in some areas, underinvestment in transportation
infrastructure. This underinvestment has effectively constrained the growth in the supply of
“well-located” land at a time when demand for this type of land has grown very strongly. The
result has been a higher average price of land in our major cities.
Another possible structural explanation is that the higher land prices reflect an upward
revision to people’s expectations of future income growth and thus the amount they are
prepared to pay for housing services. One possible reason for this is that the growth of our
cities generates a positive externality – by bringing more people together competition is
improved and productivity is higher. While this might be part of the story, I think it is unlikely
to be a central part. Real income growth per capita did pick up markedly from around the mid
1990s, but it has subsequently slowed substantially, with apparently little effect on the price
of land relative to income.
So the story is really one of increased borrowing capacity, strong population growth and a
slow supply response.

....work done by my colleagues at the
Reserve Bank of Australia (RBA) has estimated that a rise in wealth of $100 leads to a rise in
non-housing spending of between $2 and $4 per year. (11)....Interestingly, other colleagues at the RBA have recently been examining this idea, again
using household level data from the HILDA Survey.13 They find clear evidence in favour of a
collateral channel, especially for younger households who are more likely to be credit
constrained. In contrast, they find no evidence in favour of the traditional pure wealth effect.
Instead, their evidence is consistent with the alternative expected-income idea. Perhaps, the
most intriguing aspect of their results is that when housing prices in a particular area
increase, renters in that area increase their consumption. The increase is not as large as for
owner occupiers, but it is an increase. The conclusion that my colleagues reach is that it is a
common third factor such as higher expected future income, or less income uncertainty, that
is, at least partly, responsible for the observed association between housing wealth and
spending.

That last point is interesting, and I think ties in with this NBER paper from Hsieh and Moretti that I recently discussed, which suggested that housing constraints in high productivity cities cause some of that productivity to be captured as economic rents by laborers and real estate owners in the city. The Windsor, Jääskelä and Finlay
paper he cites finds that when home prices rise, there is no measurable wealth effect that leads to growth in consumption. Instead there is some credit expansion for credit constrained households and there is, surprisingly, increased consumption for both owners and renters, which they take as a signal of increased income expectations. (I think we could also say that the credit expansion, in the aggregate, is related to positive future income expectations.) I think it is plausible that the base causal factor here, given a city with high or increasing productivity, could be the housing constraint, which limits labor inflows to the city, pushing up wages and real estate rents. This would lead to higher real estate rents and values, and to higher income expectations, credit usage, and consumption from both renting and owning households.

To the extent that labor movement is flexible, these rents should eventually accrue mostly to real estate owners. This should happen most readily among low income households who benefit the least (in absolute terms) from the city's productivity opportunities and who spend a larger portion of their incomes on rent. I think this fits well with the common observation that urban real estate is being developed only for the ultra-rich. That is because very high income workers are still claiming some of the rents of the limited access city, and the process of building new high end real estate is the process of real estate owners claiming more of those rents. Thus, the largest beneficiaries of urban policies that dis-incentivize building and require more low rent building are probably the city's very high income wage earners. This is because their marginal housing consumption is more discretionary, so they can reduce their real housing consumption to retain more of the available rents. I wonder if this is why the priciest units seem to be purchased by what Krugman referred to as "domestic malefactors of great wealth, but also oligarchs, princelings, and sheiks", because the very high income households who are in the city for productive reasons would be reducing their housing consumption during their tenure in the high-cost city - possibly downsizing their urban space and pairing it with a spacious home in the country. The constricted supply turns the highest rent units into very effective luxury status goods.

I am starting to wonder how much of the measured trends in income inequality have their source in the housing policies of the major cities. I think there was generally an expectation that the technological revolution would make location less important. But, we have found that for the creative functions behind that technology, location has become more important. And, globally, cities have developed housing constraints that have prevented them from accommodating the inflows of creative and productive workers who find value there. Lowe mentions the importance of transportation. Will the trends in income distribution reverse when the self-driving car becomes widely available?

In the meantime, I think Lowe has missed an important implication of these various findings. He doubts that the higher value of urban real estate has come from higher expected incomes. He says, "Real income growth per capita did pick up markedly from around the mid 1990s, but it has subsequently slowed substantially, with apparently little effect on the price of land relative to income." But this is because real incomes are lowered by the rising rents themselves. Income expectation in the cities are, indeed, strong. But the rising incomes are eventually claimed by real estate owners.

Distributional Effects of Home Price Changes

In an economy without supply constraints, rent and home prices should rise with inflation over the long run. In this case, rising income expectations should coincide with higher real interest rates, and future real increases in housing consumption would come from future increases in the real value of the housing stock. This is actually a good description of the housing market of the 1990s, when rent inflation wasn't excessive (until the last half of the decade) and price/rent ratios were low. So, I think the positive correlation of income growth expectations and home rents and prices is only operative in a constrained supply context. Or, to restate this in a more narrative way, without supply constraints, households with rising incomes wouldn't pay more to rent or purchase homes; they would just build better homes to add to the beginning housing stock. In that case, there wouldn't be a correlation between rising incomes and rising rents or prices of the existing housing stock.

Here, I would like to pull in the recent paper from Song, Price, Guvenen, and Bloom at the LSE. They found that essentially all of the change in income inequality since 1982 has happened between firms. In other words, distribution of incomes within firms has been relatively stable. The highest income workers aren't earning relatively more than their co-workers than they used to. Rather, workers of all incomes at the highest paying firms are making more than workers at other firms.

Some of this could be explained, I think, by changing firm structures. For instance, Apple's corporate structure outsources much of the lower value-added positions. More generally, technology-related fields have largely developed around human capital, more than physical capital, leading to firms filled with high income professionals and entrepreneurial development-oriented technology workers. But Song, et. al. seem to find that the pattern holds when controlling for industry type, worker age, gender, and tenure, firm size and region, and is stable over the time period.

I have included the graphs by region here. The x-axis on the graphs is the income percentile of the worker. The blue line is the change in income for workers in each percentile from 1982 to 2012. The red line is the amount of that change that can be explained by the average income of the firms the workers in that percentile worked for, and the green line is the amount of that change that can be explained by the change in incomes for that percentile, relative to their co-workers.

When the data is separated by region, there are distinct bumps in the bottom 30% of incomes. Except for the very lowest wage earners, these workers saw rising incomes compared to their coworkers. We see the opposite pattern at the top of the wage scale, though not generally as pronounced, where high income workers saw their incomes rise slightly less than their co-workers, except for a slight positive bump for the top 1%.

Some of this must be related to organizational shifts. Maybe there is an explanation for the hump at the low end of wages related to the shift from manufacturing to health & education and leisure & hospitality. I wonder if there is generally a bit of a rural vs. urban divide here, and that the distribution of firm wage gains would be flatter if we applied location specific inflation adjustments.

A careful viewing of the scales of these graphs shows that the West and Northeast regions have much sharper divergence between the top 15% of firms and the rest of the firms - a divergence of earnings growth between high income firms and other firms of about .4 compared to .2 in the other regions. These are the regions where the cities with the worst housing problems are located (NY, San Francisco, San Jose).

The urban housing supply issue may be a fundamental driver for all of these issues - income variance, the sense that we are in a "bubble" economy where income gains are soaked up by rising asset prices, the sense that real incomes for the lowest income earners are stagnant.

More Distributional Effects of Home Price Changes

Let me define a static housing context as one where interest rates are stable, and the real housing stock is expanded at the rate of real income growth, so that each year, households spend the same portion of their incomes on housing, and they increase the real value of their homes (through size, location, etc.) as their incomes grow.

Now, if long term real interest rates decline, this simply reflects a change in the price that current savers have to pay for a claim on future rents. This is a transfer from future buyers to current owners. There are some distributional effects here, but only between owners. High long term real rates probably promote economic mobility by allowing new savers to more easily pre-pay future rent and by reducing the nominal value of past savers. But, there is no first-order effect on home consumption (rent). This explains some of what has happened over the past 20 years or so.

But, all else equal, what if there is a shock to expected future housing supply? This will also cause home prices to rise, but now, this isn't simply a transfer of cash from buyers to sellers. In this case, the buyers are actually buying more rent. One way of thinking about it is that a single property now represents a larger portion of the future housing stock than it did in our beginning stasis condition. This is similar to buying stock in a firm with that has an above average growth rate because it is gaining market share. It fetches a higher price, just as the home now fetches a higher price. At the point of recognition of this change, home owners will receive a one-time capital gain. This is like owning shares in a firm that announces a positive product development. Or, maybe, more precisely, it is like owning shares in a firm that announces protectionist developments - say, the value of a domestic tire manufacturer after a large tire tariff is announced.

In that scenario, the ability of securities markets to pull future developments into the current price creates something that looks like a disconnect to a naïve observer. Rent isn't forward looking. It reflects the current supply and demand for housing consumption. So, the higher home price will appear to be inflated. But, since the home itself is a static property, it's value relative to a given future housing stock is static. A new owner must purchase that home's portion of the future housing stock, whether they want to or not. If housing consumption continues to command a stable portion of total consumption expenditures, as it has for more than 50 years, then there may be conceptual value to thinking about home values in terms of future housing "market share".

Thinking about it this way, adding potential supply will reduce the value of existing homes by reducing their future expected housing "market share". I have wondered how much the lack of available investment in real estate has been a contributing factor to lower real long term interest rates. But, I wonder if this presents another way of thinking about that. Normally, risk free real interest rates would tend to rise and fall with expectations for real economic growth. So, current low real interest rates suggest low growth expectations.

I wonder if this is related to the current tendency for home prices to rise to unusual levels. The expected growth of the housing "market share" of individual home owners is basically a claim on future nominal income growth. It is the result of artificial limits on housing expansion - limits to real growth, which operate as growing claims by real estate owners on future nominal incomes. The added value of home ownership and lower expected future real income growth expectations are two sides of the same coin.

This is sort of an application of limited access vs. universal access. A universal access economy will lead to creative destruction and growth, and real risk free interest rates will reflect the related optimism. A limited access economy will lead to rent-seeking, and real risk free interest rates will reflect stagnation. A large portion of our economy (housing) is characterized by limited access - first through urban building policies, which pushed real interest rates down slightly in the 2000s, then through limited mortgage access policies, which pushed real interest rates down to the extremely low levels seen since the 2008 crisis.

Friday, August 28, 2015

Excessively accommodative monetary policy led to over-expansion of credit and mal-investment, leading to a massive over-consumption of housing. Where that overconsumption couldn't be met with supply, prices skyrocketed. As predatory lenders approved households for more and more housing, households bid up the price of homes, pumping up the price of owner-occupied properties as households moved out of their rented apartments into their shiny new McMansions which were more house than they should have ever been allowed to own.

As regular readers know, I have previously pushed back against this narrative. Well, now that I have reviewed the data, I must confess that this narrative does fit...

...It fits the 1970's, that is. Which, it so happens, was a period that actually had excessive monetary accommodation. Well, the narrative fits if you remove the rapacious bankers and replace them with reasonable households.

I might need to explain the graph.

The green line is core inflation - a pretty good proxy for monetary policy, given that our stated policy is an inflation target.

The purple line is shelter inflation, relative to core inflation. Owner-equivalent rent inflation only goes back to the early 1980s, but since it accounts for the bulk of the Shelter component, shelter is a very good proxy that goes back much farther. I have not adjusted this measure to remove non-owner rent inflation, but this tends to have a small effect, which would mostly just amplify the patterns we see here.

The blue line is rent inflation for non-owners, relative to core inflation.

As we enter the 1960s, inflation is low and shelter inflation is unremarkable, but beginning in 1966, inflation kicks up and remains high until after the Volcker adjustment. Notice the interesting pattern throughout that period. Whenever inflation shoots up, relative rent inflation moves down and owner-equivalent rent inflation moves up. Notice, too, how the late 1960's and late 1970's episodes, which coincide with the sharpest owner-equivalent rent inflation also see run-ups in homeownership rates and in real estate values. That is what a demand-side housing boom looks like.

What caused me to look at this more closely was a very interesting speech by Philip Lowe, Deputy Governor of the Reserve Bank of Australia.(HT: Matthew Klein via Noah Smith) (I will have more to say about that speech in my next housing post.) One factor Mr. Lowe mentions regarding recent home price behavior is:

In the 1970s and 1980s, regulation of the financial system and high inflation served to hold down land prices artificially. They did this by limiting the amount that people could borrow. When the financial system was liberalised and low inflation became the norm, people’s borrowing capacity increased. Many Australians took advantage of this and borrowed more in an effort to buy a better property than they previously could have done. But, of course, collectively we can’t all move to better properties. And so the main effect of increased borrowing capacity was to push up housing prices, and that means land prices.

﻿

I'm not sure about much of this anymore. First, I'm not sure why we can't all move to better properties. There is a lot of unused space 100 to 1000 feet above the major cities, in Australia and the US, and building costs aren't as high as one might think.

I originally thought that unprecedented low mortgage payment levels in the 2000s reduced barriers to credit, and that this was a cause of low cash yields (high price/rent) in the 2000s. Mr. Lowe's assertion seems intuitively reasonable. But, this assertion is, surprisingly, not supported by the data, which shows strong single family housing starts, rising owner-equivalent rent, rising home values, and rising homeownership rates during both the 1970s and 2000s.

And, even more surprising, even while all of these indicators of growth were strong during both periods, growth in real housing expenditures stepped down to permanently lower levels coincidental with both periods. That's a pretty strange thing to see during a building boom.

Looking at the 1970s, the demand for homeownership was probably related to the high inflation of the time. Not only did homes provide a hedge against inflation, they provided a tax-sheltered hedge against inflation.

These various trends are what we would expect to see in an efficient market. The incentive toward ownership would lead to reduced renter demand and increased owner demand. Owner-occupied expenditures would be inflationary, because the tax benefits of ownership (imputed rent paid to oneself is tax exempt, as well as much of those inflation-fueled capital gains) would shift the demand curve of owner-occupied housing to the right. (Another way to think about this is that the increased tax benefits created by high inflation pushed pre-tax owner-equivalent rent up, but after-tax O-E rent may not have changed substantially.)

Higher rents and low real interest rates may have pushed the nominal price of homes up, and higher demand for homeownership may have pushed up single family housing starts. But, the trend in real housing expenditures suggests that marginal households were lowering their real housing consumption in order to transition into homeownership.

This explanation (easier access to credit because of low interest rates) was part of my original explanation for the housing boom of the 2000s, but upon closer inspection, I don't think the evidence points to a very strong effect. There are many confounding factors that create false impressions that overstate this effect. In addition to all of the moving parts described above, when real long term interest rates fall, they cause the intrinsic value of homes to rise at the same time that they would appear to increase demand for homeownership due to easier access to credit. But, the lack of an increase in real housing expenditures during these periods of low real rates suggests that it is the rise in intrinsic value that is operable. Households weren't moving up into more valuable homes (in terms of rental value) during either period.

Another confounding clue is the change in tax laws in 1986 that created new value for home mortgages because of the mortgage interest tax deduction. Note that O-E rent did begin to fall along with home ownership after inflation began to subside in the early 1980s, but permanent reductions in inflation happened slowly, and the added tax advantage of the mortgage deduction moderated the market reaction. I think this probably helped homeownership remain at about 64% into the 1990s and produced some moderate O-E rent inflation in the late 1980s, relative to renters inflation.

Beginning in the mid-1990s, rent inflation for both renters and owners began to run persistently higher than core inflation - with renter inflation tending to run slightly higher than owner inflation. As I have pointed out before, home prices didn't begin rising until around 1998. Half of the recent (temporary) increase in homeownership happened before any substantial rise in home prices. This rise in homeownership doesn't appear to have any significant effect on prices or housing consumption. This could be related to Community Reinvestment Act policies, but is unlikely that it is related to mortgage rates. Rates in the 1990s were lower than the late 1970s, but they were still relatively high. And, there were some increases in non-traditional lending, but nothing like the scale of the 2000s.

This period doesn't have the rent inflation signature of the 1970s. And, along with the persistently high level of renters inflation, there is no cyclical supply response in multi-unit housing starts during this period. The demand curve for home ownership hasn't shifted to the right; the supply curve for rented real estate has been stuck to the left. The first time credit access really became a factor in housing markets was around 2006. Since then, homeownership rates have collapsed, and for the first time, there has been a sharp divergence between the expected rate of return on homes and the rate of return we would expect in a market with broad access.

Here is a graph I have posted before, I think. Before 2008, the inflation premium inferred by the difference between real returns to homeowners and effective nominal mortgage rates was a pretty good approximation of expected inflation. In other words, housing markets were efficient. In fact, considering the persistently high rate of rent inflation since the mid 1990s, the implied return on homes in the 2000s looks fairly conservative by this measure. Even if effective mortgage rates at the time were reduced by the use of adjustable rate products, and a duration adjusted inflation premium at the time was more like 3% instead of 2%, this would not have been unreasonable. But, after 2007, this long-standing arbitrage relationship broke down. Real returns on home ownership have been higher than nominal mortgage rates, even in the face of the return of high rents.

I think there is a lot of confusion about supply and demand in housing that comes from conflating home ownership with housing consumption. The presumptions we make about housing are the equivalent of seeing a sharp rise in bond purchases, and concluding that people must be spending and consuming more. Home ownership is a claim on future cash flows, and it appears to me that the price of those claims, in the aggregate, is as systematic and regular as we would expect from any security with variable, but relatively stable, cash flows.

Home prices are efficient. Nominal housing consumption is pretty stable over time.﻿ Nominal housing expenditures seem to have reached a stasis around 1960. Notice how the slight dip in relative nominal housing expenditures is during the inflationary period where home prices and demand for home ownership is rising and real housing consumption is stable. (The bumps in real housing expenditures around 1975, 1980, and 2008 are mostly related to drops in real incomes associated with deep recessions.) The secondary effects of inflation increased demand for ownership, not for consumption. This seems to have had more effect on the housing market than limited access to credit did. Remarkably, prices and net returns on investment appear to reflect reasonable estimates of long term real required returns. Real returns on homes were declining in the late 1970s, as did real long term bond rates. To the extent that high mortgage rates created a market reaction, it appears that nominal expenditures - rents (paid and imputed) - adjusted while home prices remained efficient, leaving no unusual profit opportunities.

Supply is the irregular variable here - the variable that isn't either stable or predictable. As real housing supply declined from the mid 1990s to the crisis, relative to other expenditures, nominal consumption remained stable, and prices were an efficient reflection of constricted supply. Now, the systematic nature of prices has broken down, and will remain broken until either owner-occupier credit becomes vital again or investor ownership continues to climb long enough to fill the void. Until then, rising rent will be the story of housing.

The obsession with "bubbles" and confusion about housing means that rising rents will be widely perceived as a "bubble", regardless of whether home prices fully recover or not. As long as supply remains low, high rents will make just about any price seem high, even if it's 30% below intrinsic value. The resulting destruction of demand imposed to fix the "bubble" will do nothing to solve the supply problem. But, I suppose our lower real incomes will make us miss the homes we couldn't have built anyway a little less. We won't have to deal with any of those gauche rich people trying to buy condos in San Francisco. So, we'll have that going for us.

Thursday, August 27, 2015

By my model, last Thursday, the mean expected date of the first rate hike was around the end of November, suggesting about a 30/70 split of a rate hike in September vs. December. The mean date has moved forward to the beginning of March - a full quarter move. Uncertainty has increased, so there is still some expectation of a September hike, but this also means there is some expectation of a hike later than March. The slope of the curve hasn't changed much, but the long end has actually moved up a bit. So, on the Eurodollar curve, from the close last Thursday to today, 2016 rates are a little lower, 2017-2018 rates are about the same, and rates at the long end of the curve are up about 14bp. This suggests to me that the bond market sees hope for a more dovish future trend coming from the expected capitulation by the Fed to delay the rate hike.

This shift puts us back at about 6 months away from the next hike, continuing the pattern of the future rate hike date shifting ahead in time whenever there is not a QE program in place. There may be enough momentum to eventually break that pattern now, especially if we can see any renewed expansion in real estate investment. But, it would be nice for the Fed to just pull the rate hike off the table for a while. What does everyone think is going to happen? Five percent NGDP growth? Two percent inflation?

If the Fed announced tomorrow that there would be no rate hikes until at least June 2016, the slope of the yield curve and long term bond rates would rise immediately. Wouldn't that be normalization? That looks a lot more normal to me than what people are calling normalization.

The slope of the yield curve after the first hike is around 20bp per quarter until it flattens out around 3%. Normal yields in every recovery since the early 1960s have risen by at least 50bp per quarter, up to more than 5%. And in the recoveries before that, when rates were lower and rose more slowly, NGDP growth was topping out at 10%. There is a lot of leeway between here and normal, let alone between here and reckless.

There is a great way to know if the Fed is being reckless, too. If it ever becomes too accommodative, equity values will fall relative to corporate operating profits, like they did in the 1970s. Anti-market bias leads to this massive case of attribution error, where we each individually know just what a "bubble" looks like and how to avoid it, but "those people", otherwise known as "the market", or "us", will be led down the primrose path.

Wednesday, August 26, 2015

So what should the Fed do? We would suggest that the Fed do nothing, but in a creative way. The Fed should announce that it will indeed hike short term interest rates as planned in September 2015, and at the same time, that it will also initiate a new round of quantitative easing, initially at a low value with the amount being data dependent with respect to actual economic conditions within the U.S. economy, with the stated goal of achieving a nominal GDP growth rate target it believes it can attain by the second quarter of 2016.

At first, this seemed a little frivolous, but the more I thought about it, the more this started making sense to me. This fits well with my conception of our current economy that is bifurcated between (1) an industrial expansion which is happening, more or less, at terminal velocity, which would probably normally be associated with short term interest rates at least in the 2% to 3% range and (2) a real estate economy which is held back by regulatory barriers to building and to credit access.

Real housing consumption is, therefore stagnant, and the relatively low elasticity of housing demand leads some of the real growth in the industrial economy to bleed into real estate. Limits to real housing expansion mean that this increase in housing demand mostly becomes rent inflation.

So, I have, tentatively, held the opinion that early rate hikes may not be that important, because housing isn't constrained by rate spreads and the industrial economy can withstand some rate increases. Recent market reactions suggest that I might have been too optimistic about that.

In any case, it seems to me that we have come to a new consensus that debt-financed housing is in disfavor. All things considered, housing wouldn't have to be financed through highly leveraged bank loans. There are numerous ways that we could conceive of a functional housing system, and some would probably operate more smoothly. But, the problem is that since there is a focus on the misguided idea that the main problem was high home prices, unmoored by fundamental values, there tends to be a satisfaction with prices that remain low. This satisfaction requires a willful disregard for the alarmingly low rate of new homebuilding and high rate of rent inflation, and a disregard for the unprecedented level of excess returns available to home owners at current price levels. So, we have completely undermined our previous system of home ownership (in that expected returns cannot fall to non-arbitrage levels) and there is no consensus demand to replace it with a functional system.

Where this is leading is to a pre-HUD context, with very low homeownership rates and high equity levels (low leverage) for homeowners. If this is the context we are determined to create, then we need to provide enough liquidity in the market to fund cash ownership. And, as long as we withhold that liquidity, homebuilding will remain very low, rent inflation will remain high, and real estate owners will capture excess gains.

When we did have this sort of context before 1960, the banks held a large amount of securities in bank credit (treasuries, etc.). I am no banking history expert, but I suspect that part of what was happening was that there was more demand for insured bank deposits than there was supply of bank assets with credit risk, so banks met some of the demand for deposits by holding treasuries. (Please, correct me in the comments if I am wrong.) Maybe today low risk non-bank savings vehicles would fill some of this demand. Or, maybe even those avenues create some level of bank deposits. Again, educate me in the comments if you can.

Note: the x-axis begins in 1973 on this graph.

The last piece of the puzzle here is that with our new policy of paying interest on reserves, reserves are basically a substitute for short term treasuries. Benjamin Cole, blogger and occasional IW commenter, favors a sort of permanent QE. And, thinking about it in terms of bank balance sheets, I think he has a point. This is probably inevitable.

Now, I'm not sure what factors have led banks' overweight low-risk holdings to be in reserves today vs. securities back then. Is it because of the peculiar path of monetary policy an interest on reserves beginning in 2008? What if there was a way for the Fed to swap reserves for treasuries with the banks without creating deflationary side effects? In any case, it seems as though the large Fed balance sheet is only different from the pre-1960 context semantically.

And, if that is the case, then it does seem like there are two tiers to future monetary policy, if we are going to retain interest on reserves. First, is management of credit through the level of interest on reserves, and second is management of the level of bank deposits through open market operations. To this end, a rise in interest on reserves coupled with large scale purchases of treasuries makes sense. Treasury purchases would allow deposits to rise, even as banks were using deposits to purchase low risk securities in the form of excess reserves. Presumably some of the cash from the open market purchases would make it into real estate markets, allowing real estate values to rise to non-arbitrage prices without the use of destabilizing debt.

This is all academic, really, because the same errors that have led to a consensus against mortgage growth would lead to curtailment of asset purchases if returns to home owners ever reaches a reasonable level, and, further, most of the potential benefits from injecting liquidity in the housing sector would depend on removing the fetters from urban residential building markets.

The public wants to spend about 18% of personal expenditures on housing, but we have a number of policies that divert those expenditures to real estate owners instead of to developers and builders, then when the inevitable pressures to rent inflation and real estate values build, we complain of stagnation and the "bubble economy". But, instead of prescribing supply, we prescribe demand destruction. Nothing besides real expansion of housing (mostly through the unleashing of location) will solve the stagnation problem, and I don't see any immediate possibility of remedying that problem.

But, in the meantime, Benjamin's and Ironman's QE4+ would be one way of allowing real estate prices to reach a reasonable level. We would know when we had gone too far because inflation would begin to rise. If real estate prices rise in a low leverage environment and we don't see consumption inflation, then who is to complain? In fact, to the extent that new housing stock is encouraged, QE4+ would be deflationary. Most of our current inflation is due to rent inflation because of the housing shortage. If your complaint about the regime that I just described is that only high net worth households would be able to own homes, then I will suggest that you're arguing for a return of widespread mortgage financing. If we pick neither, then we are picking a regime that not only locks to net worth households out of ownership, but also keeps their rents high in order to fund the excess returns of their landlords. Of the three options, our current regime is the worst. I'm afraid that the other two regimes require supporters who are willing to accept market prices, which is a sadly unpopulated cadre these days.

Tuesday, August 25, 2015

Scott discusses "How bad government policies make us meaner". It's hard to excerpt, but the basic idea is that if we legislate favorable contracts, we create incentives for discrimination and abuse. A landlord of a rent controlled apartment has no incentive to treat tenants fairly. There will be a line of tenants ready to take the current tenant's place, in any case.

Proponents of the minimum wage frequently reference these factors in defense of minimum wages - the idea of efficiency wages, that there will be lower turnover, and that employers will have a larger potential labor force because workers will be more incentivized to take the higher wage jobs. Among the outcomes, in other words, employers will have more leeway to be abusive and prejudiced in their hiring decisions, and workers will be more apt to put up with indignities in order to keep their jobs.

This is related to my post from the other day about the importance of freedom of entry. Really, this is all related to Mike Munger and Sam Wilson's Euvoluntary Exchange project. I must be honest that in some ways I am still wrapping my head around the conceptual insights of EE. But, a foundational element of the concept is that the availability of nearly equivalent alternatives is probably the most important element in creating a culture of fair dealing. If you crawl out of the desert, parched, to an oasis, the difference in ethical context of meeting one person with some water versus meeting 2 or 3 people with water is enormous.

Policies that intend to help workers or consumers by lifting particular contracts away from available alternatives are very short sighted. They are inimical to a civilized and fair society.

Monday, August 24, 2015

I have been looking at wages by sector, and I noticed some interesting patterns. I don't know, maybe everyone already knows this. But, I thought it might be worth sharing. (I should note that there is one short-cut here. Employment shares are based on all private employees, but wages and hours are based on non-supervisory and production workers, because a longer history of data is available.)

First, there has been a shift, which we can date to about 1984, where sectoral weights in employment have been pretty stable, except for three categories. Manufacturing has declined from 19% of private employment to about 9%. About 7% of this shift has been replaced by Health & Education (H&E)employment and about 3% by Leisure & Hospitality (L&H). Manufacturing employment has been falling much longer than that, but during this period, the shift has been contained within these three sectors while the remaining sectors have remained fairly stable.

I should note that this is private employment, so the Health & Education sector is dominated by health care employment.

The first interesting finding to note is that H&E (purple) has seen steadily higher hourly wage growth compared to the other sectors. In 1984, average hourly wages in H&E were about 10% below average, and now are about 5% above average. M (blue) wages have declined from about 7% above average to 5% below average over time. L&H (red) is a significant outlier. Average wages there have run at about 60% of the average for the entire period.

If we aggregate hourly wages using the weights of sector employment in 1984 (orange), we see that the shift from M to L&H and H&E has had no material effect on hourly wage levels. (The black line representing actual hours worked is mostly hidden by the orange line representing the hours worked at fixed 1984 sector weights.)

When we look at weekly hours, we see that the M sector is an outlier, with much higher average hours than other sectors. H&E is slightly lower than average, and L&H is again way below average. By sector, average hours has declined slightly in L&H, but the other sectors are pretty flat over time. Here, if we aggregate hours worked by sector using 1984 weights, we see that aggregate hours worked also would remain fairly level. In other words, the drop in average hours worked of a little more than 1 hour per week (about a 4% decline) is almost entirely related to a shift in sectors.

So, when we look at weekly earnings, we see that L&H earnings are less than half of the other sectors. The combination of slightly higher average wages and slightly lower hours puts H&E earnings right at the average. And, the high average hours worked leads to higher weekly earnings for M.

So, there has been a 4% decline in average earnings over 30 years due to sectoral shifts, due to lower hours worked, not due to lower hourly wages. But, within these averages, there has been an increase in L&H employment, from 8% to nearly 11%, which is characterized by much lower average earnings. It seems as though this would lead to a sort of hump at the lower end of the wage scale, relative to 1984.

Outside of the L&H sector, if we compare all sectors except L&H (light blue line) to earnings at the 1984 sector weights (orange line) what we generally see is a substitution of fewer hours for higher pay, with the net effect being a slight increase in average weekly earnings compared to sector weights of 1984 for workers outside the L&H sector.

I don't know if there is any actionable information here, but maybe there is something here to add to a perspective of changes over time in the labor market.

One impression I want to be careful not to give is that there is some sort of fatalism in these trends. There are surely a mixture of supply and demand factors in the changing context of job characteristics. These shifts may reflect changes in worker preferences as much as changes in employer demands. For instance, the past 30 years has seen the remaining shift toward a gender-neutral labor force. The labor force was more than 70% male after WW II. By 1984 it was down to 56%, and is now around 53%. Some of the shift in American production may be a reaction to a more feminine labor force. Possibly, some of the movement in manufacturing employment out of the country is a reaction to American preferences for shorter work weeks.

I think we have a tendency to falsely treat labor markets as if they are imposed on workers. Politically, the left naturally does this as an outgrowth of the progressive tendency to view economics through the lens of perceived power imbalances. But, the right has this tendency too, as we saw in the expectation that Obamacare would lead to a massive shift from full time to part time work, as if employers could single-handedly determine the terms of employment. If avoidance of the mandate was valuable, it seems as though some Coasean bargain could have been struck. If it was, it appears that the bargain did not include a widespread reduction in hours. There have been anecdotal reports of firms switching positions from full time to part time. But, the lack of any significant aggregate shifts suggests that, on net, the workers filling these new part time positions were being pulled from other employers, not shifted from full time positions. Possibly, if there was added demand for part time workers from some employers, there was a resulting shift among other employers to move more to full time workers. In the big, messy world of voluntary associations, it is difficult to imagine all of the possible ramifications. What does seem clear is that there has been no clearly discernible deviation in employment trends from what historical experience might have led us to expect. Like with many regulatory issues, much of the effect of Obamacare, pro or con, will be in unmeasurable changes in quality of life that will not be easily confirmed with readings of employment or GDP growth.

Ironically, while the right-wing expectation for a surge in part time employment failed to support criticism of Obamacare, that same failure also punctures the progressive assumption that labor lacks the ability to influence the terms of employment. The demands of labor have an enormous effect on the shape of the labor market. It doesn't seem that way to us, because the labor market is an emergent phenomenon. It appears to be presented to us, as individuals, in a sort of take-it-or-leave-it proposition. But, it is just as true that each of us, individually, enters, say, a Macy's with a sort of take-it-or-leave-it proposition. Most of us were not asked what color oxfords we would prefer to wear this year or how wide we would like our neckties to be. At the point of entering their store, Macy's does offer us a take-it-or-leave-it proposition. But, is there any question that the demands of their potential shoppers were the primary focus of every decision that involved the stocking of their stores?

Unfortunate predispositions about the nature of employers and firms keeps this understanding from gaining a foothold in our universally accepted presumptions about the economic world.

Friday, August 21, 2015

Along with today's decline in equity markets, treasury yields and inflation expectations also declined. Five year forward inflation breakevens are now at 1.13%.

Here is an update of the graph I posted a few days ago, showing that short term TIPS yields have pushed even higher. It's a little hard to pull out of the data, because TIPS markets have only recently developed, but this pattern of large premiums in short term TIPS yields also emerged in the summer of 2007 when the Fed signaled ambivalence about early difficulties in the mortgage market and emerged again before the fateful September 2008 Fed meeting. I don't see a sign of this pattern at other times. For instance, forward inflation expectations dipped down after the first two rounds of QE ended, but short term TIPS didn't signal deflationary shocks at those times.

Looking at the forward Eurodollar markets, I also see worrying signals. The recent fall in interest rates has not been associated with a shift forward in time of the first rate hike. That is still expected to happen between in October or December, as it has all summer. The expected date of the first rate hike had been moving ahead in time, remaining about 6 months in the future. During this time, I read the bond markets as gaining confidence. The yield curve at the very short end slightly flattened, but the terminal rate moved up nicely, signaling higher expectations for both inflation and real rates to move toward the Fed's stated goals. But, in June, bond markets appear to have accepted a resolve from the Fed to raise rates this year. The expected date of the first rate hike stopped moving forward, and when it did, the slope and terminal height of the yield curve began to decline, along with inflation expectations.

And now, in the past few weeks, we have TIPS markets signaling a deflationary scare. All of this, together, says to me that the bond markets do not have faith that the Fed will respond to current weakness in a timely manner.

If the bond markets are right, the question is, "Is this August 2007 or September 2008?". On the one hand, there is some positive momentum in labor markets and industrial markets (outside of oil exploration). There is no momentum in construction or real estate credit to destroy. I take this as a sort of positive. There is not a lot of activity to undermine there. The economy's momentum is not dependent on real estate. And, even though the zero lower bound distorts the yield curve, the long end of the curve is around 3%, and I doubt that it could distort it that much. Normally, I wouldn't worry about more than a minor equity correction if the yield curve is not inverted. Also, corporate leverage is low, profits are strong, and valuations are reasonable. Equities shouldn't collapse unless there is a collapse in nominal incomes that creates a deep decline in corporate profits, like it did in late 2008. Those factors suggest that the initial reaction to a hawkish error wouldn't necessarily be disastrous. Equities didn't peak, surprisingly, until October 2007, and slowly declined by about 3% a month after that. Profits had been falling slowly since 2006. The collapse in equities in late 2008 was more or less proportional to the collapse in earnings that came after the September-November 2008 tightening. On the other hand, 5 year forward inflation expectations are about where they were in September 2008.

It is certainly time to start thinking about forms of defense. I'm not sure there is a safe and inexpensive hedge available. Directional positions are dangerous, because they are basically a bet on the arbitrary decision of a committee of political appointees. It's unfortunate that we impose this sort of uncertainty on ourselves. Regardless of the policy decisions that happen as we move forward, how many productive activities are on hold now because of the uncertainty? Even if we didn't have a market-based currency regime, wouldn't it be nice if the committee could quickly do something like simply announce that they would buy $100 billion/month of new treasuries until 5 year inflation expectations increase to 2%? It seems to me like a conservative position to take, but it would be made out to be a big deal. And, everyone from Rand Paul to Bernie Sanders would be talking about how the Fed was just covering Wall Street's backside, as if the only problem we have is a drop of a few points in equity markets. As if labor and capital aren't part of a symbiotic relationship where early signals of trouble for both are often visible in capital markets.

Thursday, August 20, 2015

The Fair Trade (FT) coffee initiative attempts to channel charity from consumers to poor producers via increased prices. We show that the rules of the FT system permit this rent to be eliminated due to free entry and costly excess certification of output. Using data from an association of coffee cooperatives in Central America, we verify that expected producer benefits are close to 0 when we take into account the output that is certified but not sold as FT. Our results illustrate how free entry undermines the attempt at extending charity via a price distortion in an otherwise competitive market.

In the realm of characteristics required for functional markets, it seems to me that freedom of entry is so important in scale compared to all other factors that it should be the cornerstone of all policy and market analysis.

Fair Trade coffee is a clear example of this point. As Michael Munger points out, it is impossible to give away money. More, specifically, if there are low barriers to access, there will be an arms race of expense and effort to exploit that access. Even if the point of the transaction itself is to bundle charity with commerce, and everyone in the process is morally invested in that outcome, they will be powerless against the pressure of freedom of entry.

This is why individual ventures can earn persistent excess returns on investment (because their founders are especially skilled, or they picked a fortuitous location, or they have intellectual or organizational assets), but investors in equity markets generally do not have the same opportunity. There may not have been unlimited access to the founders' skills, but once those skills have been capitalized, the price of the ensuing expected profits will leave nothing extra for the marginal investor, on average.

If Fair Trade wants to ensure positive returns to growers, on average, they will have to limit access. Charity is not achievable here - only patronage or market-clearing incomes. The difficulty with intuitions about progress is that patronage appears to be the charity that open access failed to achieve, but it is really just one edge of a double edged sword, the other of which is exclusion. And, it fails in that it generally leads participants to expend effort toward gaining access instead of producing.

Fair Trade, as does all open access trade, induces its producers to more productive work. If they utilized patronage to create income for their producers, the producers would cease to be induced to higher productivity, but they would be induced to ensure their access to the gains. And, once they had access, their interests would be better served by complaining to Fair Trade buyers about the low price of the beans than by performing the difficult work of lowering costs.

This is an obvious sign of limited access regimes that create rents and underproduction. The producers will focus much of their energy on complaining about prices. Collect all of the stories you may have heard on NPR, for instance, where producers were complaining about prices (including wages) or funding, and note if any of them involved producers in a free access market. (Some may be in a free access market that they are trying to close.) To insiders, these complaints will seem reasonable, because those insiders will be working very hard within their institutions. Productivity improvements don't come from working harder. They come from innovations, large and small, and, if anything, result in easier workloads most of the time. So, rent-seeking insiders naturally feel indignation when their complaints are met with skepticism. This insight does not come naturally from their conscious experience. Skepticism about their value seems to be a challenge to their sincerity or their commitment, when it is really about being vulnerable to competition. (Though, for someone who attributes moral value to labor-captured rents, even this is an insult.)

All policies should be viewed through the lens of access.

Immigration and trade are issues about access limitations. Some American workers may earn rents by keeping out Mexican workers. (This is probably the case in some specific industries, but in the aggregate, even for low wage workers, the benefits from open access mitigate this.) But the other edge is the cost Mexicans are willing to endure to gain access. It is a measure of the dysfunction of our national tendencies on this matter that there would be less deadweight loss if our border agents were corrupt and simply accepted bribes to allow Mexicans to enter instead of engaging in our policy of suffering and desperation in the deserts of the southwest. (Of course, a system of fees and commitments would be better than bribes, but either would be better than our current policy.)

Our refusal to create a functional mechanism to accommodate some of the demand for entering U.S. labor markets, protects some rents for some groups of low-skill American workers, reduces real incomes for many others, and turns the price Mexican workers are willing to pay to gain access into waste. This is likely a net loss for the U.S., and is almost certainly a net loss if we include the costs to the would-be Mexican immigrants. That demand is there, whether any particular Americans want it to be or not. The question is only whether that demand is met through a functional process of managed entry or through sweat, and occasionally blood, spilled in American deserts and the deterioration of the rule of law. Politics at its worst is frequently the mirage that we can indulge our prejudices and discomforts with the threat of force. Despite the pretense that there is some factional debate here, there is really a national consensus for continued dysfunction on this issue because we have lost the communal understanding that civilization is the manifestation of universal access. This would be an ideal that would be difficult to realize even without so much confusion about the relationship between rents and shared abundance.

That confusion causes many immigrant advocates who decry deportations and other indignities, nonetheless to call for prosecution of those who would employ those immigrants. Generally the people I know in Arizona who are exorcised enough on these issues to march and do public advocacy are against NAFTA and other trade liberalization policies. They generally don't accept the notion that access limits economic profits. They would dismissively say that is "trickle down" economics. And, maddeningly, this leads them to supporteconomic exclusion.

Are you concerned about food deserts in American urban communities? If 90% of your effort isn't directed at removing barriers for firms to locate in those areas, then are you engaged in the topic to make utilitarian improvements?

Are you concerned about education? Remove barriers to entry for schools and for teachers. Every other remedy in the world will not add up to the weight of that factor. Pleas for funding and higher wages are a sign of the problem, not the solution. Very poor families in Kenya use their cell phones to make payments to private schools. Neither the schools nor the cell phones were made available to them because education entrepreneurs and cell phone manufacturers went on Kenyan airwaves pleading for funding. Those schools appeared, in spite of all the seeming obstacles, because costs were (quietly) lowered, not because funding was (loudly) increased. The difference in process between competition and patronage is massive - orders of magnitude over time.

If you think the sharing economy is damned by the lower incomes its producers make, please turn the sword over. You've missed something.

Firms asking for protectionism explicitly claim it is to raise their profits (for the sake of their workers, of course). If you think the wages of current taxi drivers will fall because of new competition, think of the value of taxi medallions. Think about the idea of negotiating power with regard to that issue. If ride-sharing becomes ubiquitous, would you rather have been a taxi driver or a taxi medallion owner? Is it even close? In the absence of barriers, firms are practically powerless. If you think our society is bedeviled by the power of corporations, then surely all of your work is directed toward the easier creation of more corporations. Surely, the elimination of rents for taxi firms is something to celebrate. Surely the encroachment of Mexican and Chinese firms into American markets is something to celebrate. Surely simplified regulations would be something to celebrate.

If this seems wrong to you - if you approve of all of those limited access regulations - because those limits produce rents for American workers and raise their wages, then you must believe that labor has significant power to claim producer surplus - even for taxi drivers. They do capture much of those rents, but not all. But, limited access only raises profit and wages relative to other incomes - allowing some to capture a larger portion of a smaller pie.

First and foremost, freedom of entry is important and useful for everyone, today and in the future. But, if you agree that limited access raises the wages of the protected industry, and that it is worth the cost to everyone, then you have to believe that corporate power to claim excess profits is a minor force in American labor markets. [One way to overcome this cognitive dissonance is to conjure up the belief that rents captured by labor instead of capital actually create economic growth. As far as I can tell, this requires the following chain of logic: (1) the affected firms have sustainable rents, (2) owners will invest marginal profits, (3) there is no marginal benefit from additional investment, (4) laborers will consume instead of investing, (5) the consumption will allow firms to retain profits (presumably equal to more than the original transfer?), and (6) those profits will be invested (now to the benefit of new workers?). If a reader knows of an academic defense of the economic benefits of rent transfers to labor, please post a link in the comments.]

The oddity here is that to achieve the political goal of pushing wages above the levels created by open markets, economic rents must be created for wage earners to claim. In some areas, labor advocates achieve this through public monopoly - as with primary education. But, short of public ownership, step 2 (above-market wages) is not possible without step 1 (economic rents from limited access). Unions can capture higher wages for their members, but there has to be some source of protected profits for the unions to capture. In areas like the U.S. auto industry in Michigan, this was sustainable until globalized competition reduced the excess profits those firms could claim from their geographic advantages. But, without those rents, unionization became an impairment.

As the paper I pointed to the other day from Hsieh and Moretti discussed, cities can develop natural sources of productivity, and wages in those cities can rise if there is limited access to housing. Similarly, this recent paper from Song, Price, Guvenen, and Bloom at the LSE, which attributes essentially all the increase in measured income inequality since 1978 to inequality between firms. In other words, wages across income levels rise within successful firms. Some set of complex processes appear to distribute producer surplus broadly. (Maybe even the issue of firm-based income inequality is related to these high-cost, limited access metropolitan housing policies. Those rents move through laborers, but tend to flow to real estate owners.)

So, advocates for higher wages fight open access economic regimes. This frequently means fighting for corporate favoritism. Those who disfavor ride-sharing firms because their wages are lower than taxi firms are an example of this. Calls for protectionism in order to protect workers are an example of this. Just about all calls for licensing, regulation, and public spending on projects that will create "good jobs" fall in this category.

The implication of closed access policies is that wage earners will claim some of the producer surplus. The error is in seeing the world in terms of favored groups (labor) and disfavored groups (capital), missing the unmeasurable outcomes of these policies, and selectively measuring the visible outcomes. Open access markets create higher incomes for consumers while limited access markets create a transfer from consumers to producers. Limited access policies miss the forest for the trees.

So, ironically, wage advocates tend to be the most vocal supporters of crony capitalism, even if it is inadvertent. Money illusion helps to hide the problem here, because these policies tend to lower real incomes through higher costs. In the aggregate, labor captures much more of the value added in open access markets than it does in closed access markets. The evidence for this is overwhelming in international experience. But, Bastiat has his work cut out for him here, because all of the gains are unseen while the targeted gains of limited access are seen. Elizabeth Warren may be the premier representative of this problem. In one speech, she can bravely demand and defend thousand-page regulations while decrying the revolving door of lobbyists and regulators - to fawning applause. I think one way to think of labor compensation above the subsistence level is as human capital - an idiosyncratic and illiquid form of capital - so that most wages, themselves, are a form of economic rents. And, helping firms claim limited access profits from the complex regulation you helped write may be the most effective form of wage-rent-seeking ever devised. In this case, with, say, some financial firms dealing with Dodd-Frank regulations, there is frequently relatively free access, so excess profits beyond the extra cost of compliance may be difficult to retain. In these cases, most of the rents may go to the regulatory compliance officials who are using those revolving doors. Those revolving doors may be the apex of the limited access wage project - such a successful version of the policy that the downside can be seen, kind of like what we might have found with the $15 minimum wage. So, we have recognition of the beast at the high end of labor rent seeking. I suspect that these over-reaches of the minimum wage will help us rediscover it at the low end. Can the unseen ever be seen in the big, muddy middle?

Wednesday, August 19, 2015

The slow-motion train-wreck continues. Shelter inflation moved up this month and there was no non-shelter core inflation. Year-over-year shelter inflation has moved up to 3.1% while non-shelter core inflation remained flat at 0.9%.

I think it is plausible that the housing supply problem that I have written so much about has been a key factor in recent business cycles. Note that in both 2000 and 2006, core inflation jumped up, but in both cases non-shelter core inflation was level and all of the marginal increase in core inflation came from shelter. In both cases, this was accompanied by a decline in housing starts - a very small one in 2000 and a large drop in 2006. In 2000, the Fed began lowering rates, and by the end of 2001, rent inflation began to moderate because supply had recovered. In the more recent episode, the Fed Funds rate was still holding steady at 5.25% in August 2007, after 18 months of a supply collapse. Shelter inflation began to moderate at the beginning of 2007, in spite of the supply collapse. Even before the Fed began to lower the Fed Funds rate, demand had been so undercut that housing consumption was decelerating more quickly than housing supply. The problem was so severe that neither housing supply nor shelter inflation began to recover until after QE was implemented.

﻿﻿﻿﻿

﻿﻿

What's a little frightening about forward inflation expectations suggested by TIPS spreads is that the paltry 5 year breakeven CPI level of 1.2% includes shelter. Markets know that there is no reason for this rent inflation to subside, either because of our metropolitan housing policies or our financial "macroprudence", so this 5 year forward inflation expectation must reflect an expectation of non-shelter core inflation that is basically zero. The shelter inflation issue is structural. Forward bond markets are already predicting a monetary stagnation.

Possibly credit markets have been so inoperative that some qualitative shift in mortgage lending could counteract any deflationary moves by the Fed. But, my fear is that stable inflation, which is entirely a product of our broken housing supply market, will be interpreted as a sign of demand, and the Fed will take it as a signal to tighten.

If anything, the CPI measure of shelter inflation (which is mostly rent and imputed rent) is understating the current condition of the market. Here is a CNBC story that references Zillow's recent commentary on rising rents. The comments on that story are a great example of the sort of public sentiment that Fed decision makers must be facing. If housing prices are high, it's a bubble. If rents are high, it's a bubble. If the stock market rises moderately, it's a bubble. If wages rise, it's a bubble. Populists from all political factions seem to agree on these things, and that our only remedy is to suffer - as long as Wall Street suffers too. And, any monetary accommodation is seen as yet another Wall Street giveaway. If the bloodletting hasn't fixed this yet, what else can we do, really, but try another round?

(By the way, I consider the high quality of this blog's comments to be a minor miracle.)

Tuesday, August 18, 2015

I know the TIPS market isn't the most liquid market, but this looks to me like its pretty stark signal that what markets are worried about is that the current estimate for Fed policy decisions will be disastrously deflationary. And the implications of that will make themselves clear pretty quickly after the rate hike decision.

One way to interpret this is to disregard the TIPS market. Another way to interpret this is that the question going forward isn't so much the trajectory of Fed policy rates, but the level of the natural rate. How do we figure out what the natural rate is? We watch the Fed do what they're going to do, and wait to see if all hell breaks loose. This looks like insurance against hell breaking loose. It's probably more expensive than we might expect it to be because the FOMC has a recent habit of disregarding the TIPS market and causing all hell to break loose.

Monday, August 17, 2015

Ferreira and Gyourko, with the Wharton School at U. Penn. and NBER (HT: EV) have an article that adds credence to the conclusion that it was the drop in home prices that led to foreclosures, and not the other way around. From the abstract (emphasis mine):

Utilizing new panel micro data on the ownership sequences of all types of borrowers
from 1997-2012 leads to a reinterpretation of the U.S. foreclosure crisis as more of a prime,
rather than a subprime, borrower issue. Moreover, traditional mortgage default factors
associated with the economic cycle, such as negative equity, completely account for the
foreclosure propensity of prime borrowers relative to all-cash owners, and for three-quarters of
the analogous subprime gap. Housing traits, race, initial income, and speculators did not play a
meaningful role, and initial leverage only accounts for a small variation in outcomes of prime
and subprime borrowers.

They find that negative equity explains essentially all of the foreclosures among prime borrowers and three-quarters of the foreclosures among subprime borrowers.

From the paper:

(Prime borrowers') share always
exceeds 50%, and it rose, not fell, as the boom built, from a low of 54.9% in 2000(1) to a high of
65.6% in 2008(1). Thus, the rough doubling of Subprime share over the same period is at the
expense of the FHA/VA-insured sector, not the Prime sector (Table 1).

This concurs with what I have found. The rise in subprime mortgages replaced, not prime mortgages, but FHA/VA mortgages. Here is a graph of Loan to Value (LTV) levels for each mortgage type. LTV's were improving for all types throughout the boom. They improved especially for FHA/VA loans, but this is largely a product of the declining rate of new FHA/VA loan originations, so there are relatively fewer new FHA/VA loans as time passed during the boom. FHA/VA mortgages have very low down payments, so the transition from FHA/VA loans to private market subprime loans was associated with lower LTVs, not higher. I think the conventional opinion about this is simply wrong, due to the lack of recognition regarding the falling share of FHA/VA loans. This has led to the assumption that the rise in subprime was due to either (1) a decline in the ability of households to qualify for prime loans or (2) predatory behavior from the banks to pull marginal households into mortgages. While anecdotal evidence supports these conclusions, they don't appear to be accurate regarding systemic behavior during the boom.

In the sample used in the study, in 1997, subprimes accounted for 8% and FHA/VA for 19% of mortgages. By 2006, subprimes accounted for 21% and FHA/VA 5%. This is a huge shift. And, note that those 19% of mortgages in 1997 had initial LTVs of nearly 100%. Initial LTV's declined for FHA/VA loans over time, so that they were around 95% by the end of the boom. Meanwhile, average initial LTV's for subprime loans rose from just over 80% to 85%. But, keep in mind that there was a huge transfer of more than 10% of all mortgages, from FHA/VA to subprime during that time, so those 85% LTV loans were in lieu of 95% LTVs that previously had been originated by FHA/VA. Taking these non-prime loans as a group, the average initial equity position nearly doubled between 1997 and 2006.

We can see in the first graph that LTVs were improving throughout the boom, and it was only when prices collapsed well more than 10% in 2008 that LTVs moved out of the range of the previous decade. Once they did, the price collapse was so severe, that many households were underwater with little relation to their initial LTV. By 2009, the average prime loan, which had always averaged initial LTVs of less than 80%, was underwater, and remained so until 2011.

Further, regarding the idea that these LTV trends result from rising prices that were hiding the use of newly available home equity for debt, they say, "However,
our findings imply no material economic role for this factor in accounting for foreclosure and
short sales outcomes across different types of borrowers." Controlling for refinancing or junior lien activity actually causes loss rates for all loan types to increase. In other words, borrowers who refinanced before the crisis tended to fare better, all else equal, than those who did not.

The authors speculate that this is because those who were able to refinance were more financially stable. But, I will note that if "a common factor playing such an influential
role in determining foreclosure losses across all types of borrowers" (as the authors describe it) happens to be a liquidity crunch, then households would naturally benefit from taking some liquidity before it dries up. In hindsight, we might consider describing those households as prudent rather than reckless.

------------

Have you ever noticed that macroprudential regulation is always described in terms of constraints? Caps, limits, levies, requirements, charges... Isn't the most important macroprudential factor the aggregate value of the collateral?

I know the normal reaction to that idea is that there was a bubble and that speculators pushed prices well above their justifiable levels. But, research like this shows that the damage hit prudent households. Even if we attribute all of the subprime defaults that aren't explained by price collapses to reckless speculator behavior, it amounts to a very small portion of the mortgage market, and that damage was inflicted early. By 2008, after which most of the damage was done, this was a story about prime mortgages.

There is an aesthetic reaction against the idea that stability in real estate values might have been a goal of the federal government. It smacks of corporate welfare, and it seems like an excuse to support bubbles. But, what if it wasn't a bubble? And, how are the regulatory authorities supposed to make that determination anyway? Isn't the depth and breadth of the damage that was done here enough to argue against this regulatory regime? Yet, if anything, the clamoring for all of the constraining forms of macroprudential regulation has only intensified from this episode.

The fear seems to be that if there is a credible backstop to asset prices, speculators will bid up prices even further, knowing that their losses will be limited by federal market manipulation. But, rising prices would, mathematically, mean lower real yields. And, stability has been associated with higher yields on real and low risk investments. The low interest rates subsequent to the crisis are related to fears of instability.

The implied yield of houses has been high since the crisis because of a lack of liquidity. So, as the authors show, if you really want to find housing speculators, you should look in the post-crisis all-cash market. And those investors are minting money.

It is our asymmetrical macroprudence that is bankrupting households and supporting speculators.